Is there a Backdoor to Financial Independence, Retire Early?
[Note: The words post-tax and after-tax will be used interchangeably during today’s article. Post-tax refers to contributions made to a retirement account where you do not get a deduction when the money goes in, yet the growth stays tax-deferred. A conversion is recategorizing retirement dollars with the IRS from pre-tax or after-tax into Roth monies. The terms 401(k) and 403(b) will be used interchangeably during this article. FIRE stands for Financial Independence, Retire Early. I strongly recommend reading these posts, Traditional or Roth & After-tax Investing, before reading this article to ensure comprehension of the many different terms that will be used. The website disclosure statement governs this post]
Is there a backdoor to achieve financial independence? A way to retire early and access your money? A place where you can save even when you have a higher than average income? The answer to all three of these questions is a resounding yes. Through today’s article, we will journey through the land of post-tax retirement account conversions and how they can help you achieve financial freedom.
Post-tax contributions and subsequent conversions are all the rage nowadays amongst the FIRE community and have long been a secret for those in the know. Often referred to as backdoor contributions and most commonly associated with the Roth IRA, these conversions are a powerful way to save. For today’s post, I will explain how these conversions work, what types of accounts allow for them, and the reasons why you should consider them!
The first ingredient in doing a backdoor conversion is to start with after-tax dollars. You have already paid taxes on these dollars that we will now use as contributions to a tax-deferred retirement account, our second ingredient (a traditional IRA or 401(k) will work).
These ingredients are combined by contributing to a tax-preferential retirement account in a less than preferential way. Simply put, a person elects not to take a tax deduction when they place their money into a pre-tax/tax-deferred/traditional account. Then the third ingredient is introduced, which involves telling Uncle Sam and to consider these dollars as Roth. In reality, this is accomplished by telling your IRA provider to move the funds for you, who then tells Uncle Sam of the conversion.
But wait a minute, this begs the question: Contributions of taxed dollars can be made to a pre-tax account?! The answer is generally yes, but we will discuss this later in the article.
Back to our conversation: Because this contribution was made to a tax-deferred retirement account, all growth of this money stays tax deferred until it is withdrawn. If you were only doing this and not doing a backdoor conversion, someday, you would receive the money-back in two ways when withdrawn.
The first way is as taxed dollars, and the second way is as untaxed dollars. To illustrate this, let’s move to the example below:
•A $1,000 after-tax contribution is made to a traditional IRA
•Ten years later, the money has grown to $10,000
•The money is then withdrawn
•$1,000 is returned without taxes being owed
•The remaining $9,000 is returned, but income taxes will be owed
This return of two types of dollars happens because the government is not supposed to tax you twice. So if you already paid taxes on the money, those same dollars must be returned without taxes being assessed again. As a result, since your original contributions were elected to be taxed versus taking a deduction, they are returned to you just as they went in; this fulfills the government’s obligation. Caveat time! How I love a good caveat, anyways the growth of these dollars has never been taxed, and they are in a tax-deferred account. Hence when you take the dollars out, the IRS will make you pay taxes on them.
It seems like a pretty good compromise, but wouldn’t you prefer to pay the taxes once and be done? For reasons that we will discuss later, let us assume Roth contributions are not an option. So, we do the next best thing: Backdoor Roth Conversions.
To do a backdoor Roth conversion, we must make a non-deductible contribution to a tax-deferred retirement account and then convert it to Roth dollars. Translated to English, this means: You put money into a pre-tax account and do not take a deduction for it on your tax return. You then turn around and tell Uncle Sam to consider these dollars as Roth. This is a backdoor Roth conversion, and in a perfect world, it occurs immediately. Why, you ask?
If we convert after-tax contributions immediately, then the money has not had a chance to grow, and nothing is taxed deferred yet. Thus, there is nothing to tax when the conversion is done, and tada you just paid taxes once and not twice! Think of conversions as a fancy way of telling the IRS that you have moved your dollars from a traditional to a Roth account because that is all it is!
Now conversions can be done with or without taxes being incurred depending on how you elected to make them and if they have grown. So, if you expect these dollars to grow, consider doing conversions sooner rather than later!
You are now an expert in backdoor conversions, but which accounts can these be done from and to?
Fun Fact Alert! Trivia Time
Which of the answers below do you think is right?
A. Traditional IRA to Roth IRA
B. Traditional IRA to 401(k)
C. Entirely within a 401(k)
D. 401(k) to Roth IRA
E. All of the above
So, what is your final answer? Are you sure?
If you said all of the above, you are already a finance guru! So the correct answer is E, though some require more effort than others to accomplish. Why is the answer all of the above, though?
Well, it is all of the above because you can make after-tax contributions to an IRA and 401(k); depending on your company, you may be able to contribute to both. Let’s start with the IRA account, as it is easily the more popular of the two for conversions.
Regular Backdoor Roth
With the Traditional IRA account, you can always elect to make an after-tax contribution instead of a pre-tax contribution. This contribution still counts towards your $6,000* a year limit, and for some people, it is a choice to deduct or not. For others, they simply cannot deduct the money; it must be after-tax. Happen to make above $66,000 a year by yourself or above $105,000 as if married? You will not be able to contribute on a pre-tax basis to an IRA and receive a full deduction if, and this is a big IF, your employer offers you a 401(k).
Importantly it does not matter if you participate in the 40(k) plan with your company; you only have to be offered one to be disqualified or be phased out from making tax-deferred contributions to traditional IRAs. This disqualification is the government’s attempt to level the playing field on higher-income workers!
[Please note this applies to the catch-up contribution of $1,000 for those 50+]
Not So Fun Fact Alert
If you are converting from a regular to a Roth IRA, you must ensure you only have after-tax dollars in all IRA accounts you own. The IRS views any IRA, whether a traditional, rollover, or SEP, as the same IRA account. If you have any pre-tax dollars in another IRA account, this will muddy the waters, which means mixing tax basis types. We want to avoid muddying the waters because the IRS will not let you convert after-tax amounts only; they want you to pay taxes after all! Thus, the conversion is done on a pro-rata basis of all pre-tax and after-tax amounts. If this affects you, consider converting these pre-tax amounts to Roth or rolling them into an employer-sponsored retirement account.
Mega Backdoor Roth
Transitioning to the 401(k), we know that individuals can contribute $19,500* a year regardless of their income** on a pre-tax or Roth basis. As an added benefit, some companies allow employees to contribute to their 401(k) on an after-tax basis above this amount. This does not apply to every 401(k) because companies get complete discretion on how their plan is set up. A 401(k) could offer pre-tax, pre-tax and Roth, pre-tax and after-tax, or all three variants.
Here is where things get interesting: The actual contribution limit to a 401(k) is not $19,500*. Nor is it just $19,500* + $6,500* for those 50+. It is higher, much higher. Enter King Kong, the biggest and greatest of all apes! Okay, okay, the 401(k) may not be the greatest (but in a later post, I will argue how it is), but it certainly is the biggest when we look at its overall limit for contributions.
So how much money can be contributed to a 401(k) between your company’s contributions and your own? Try $58,000* for those under 50 and $64,500* for those 50 and above. Because the IRS allows you to receive the full pre-tax or Roth benefit for your first $19,500* and $6,500*, after-tax dollars should only be added once these amounts are deposited. It is important to remember that many companies make either a discretionary profit-sharing deposit or match employee 401(k) contributions and that these amounts are always pre-tax***.
Hence, how much after-tax dollars one can put into their 401(k) entirely depends on how much match or profit-sharing they receive. If you are under 50 and your company doesn’t put money into your 401(k), then the answer is simple:
•$58,000* limit – $19,500* as pre-tax or Roth = $38,500 allowable as after-tax contributions
Because this is a 401(k), though, the company can decide to let you contribute less than the remaining allowable amount. Check with your employer!
[Note: While individuals can technically make an after-tax contribution for the total $58,000* limit, you likely should not. A person should only make after-tax 401(k) contributions for the amount above $19,500* and $6,500* if they are allowed too****. This is because if you want Roth dollars, then just contribute Roth dollars in your first $19,500* and $6,500* amounts. The IRS does not restrict 401(k) contributions in the same way as IRA accounts.]
Whoa! That was a lot of information, and I have one more note to add on 401(k) accounts before we wrap up today’s post. When it comes to 401(k)s, always check that you can do what you want before acting on it. While a 401(k) plan may allow for after-tax contributions, the plan may not let you convert it internally or externally. Remember, 401(k)s are your company’s domain, and everything is at their discretion.
In Summary: Why to Consider the Backdoor Strategy
So we made it, and what a journey it has been. You now know the ins and outs of backdoor conversions and which accounts allow them. So who should do backdoor conversions? Well, that is simple:
•Those who cannot make deductible IRA contributions and cannot make Roth IRA contributions
•Those who have the means to save and are looking to do it in a favorable tax status
•Those whose companies allow for after-tax contributions and conversions, plus are already making the standard $19,500* and $6,500* contributions
•Those who want more flexibility to access their money
Wait a minute, what is this added flexibility point? We have not covered it yet!
In essence, once a backdoor conversion is completed, it can then be withdrawn without penalty after five years (this only applies to the converted amount). The aforementioned is excellent news for those in the FIRE community or who just want the flexibility to withdrawal their funds before 59.5 without penalties.
As you can see, the backdoor Roth conversion is a powerful tool to be used in both IRA and 401(k) accounts. Use it once or use it many times. The choice is yours, but remember, this is an excellent strategy for those with the financial means to save!
So, have you ever done a backdoor conversion? Did you know about the 401(k) version of it? Let me know and chime in with your thoughts in the comments below. As always, have a great day!
*As of 2021 tax year contribution limits
**Assuming you are not considered a highly compensated employee
***Company contributions are considered compensation and eventually someday will be taxed when taken out. These contributions do not interfere with your $19,500 or $26,000 yearly limits and are always made on a pre-tax basis. It doesn’t matter if employee contributions go in as Roth or after-tax. Compensation that companies put in as a match or profit-sharing is a business expense, and they write the payment off when filing their taxes, so someone has to pay Uncle Sam for these dollars.
****Please also note not all companies allow for after-tax contributions to 401(k) plans or conversions of after-tax dollars
Mile High Finance Guy
finance demystified, one mountain at a time